The Accounting Cycle Accruals and Deferrals

The Accounting CycleAccruals and Deferrals Chapter 4

ADJUSTING ENTRIES Adjusting entries are Every adjusting needed whenever revenue or expenses affectmore than one entry involves achange in either arevenue or expense and anasset or liability. accounting period.

Adjusting Entries Adjusting Entries are journal entries recorded at the end of an accounting period to adjust income and expense accounts so that they comply with the Accrual Concept of accounting.

ACCRUAL CONCEPT Business transactions are recorded when they occur. NOT when the related payments are received or made.

Accrual Concept Accrual Concept, requires that; Revenues of the business are recognised in the accounts when earned. Expenses are recognised when incurred. NOT when the money is received or paid.

Accrual Concept – Example-1 An airline company sells its tickets weeks before the flight is due. BUT It does not record the payments as revenue because the event on which the revenue is based has not occurred yet. Once the service has being provided, we can make the adjusting entry. (i.e. We can record it as received)

Accrual Concept – Example- 2 A business records its utility bills as soon as it receives them. Not when the bills are paid, because the service has already been used.

AdjustingEntries • Adjusting Entries are necessary when accrual basisaccounting is used. • Adjusting entries allow businesses to adhere to the Matching Principle.

The MATCHING PRINCIPLE This principle, requires a company to match expenses with the related revenues in order to report the company`s profitability during the accounting period.

The MatchingPrinciple

The MatchingPrinciple • A hospital pays £20,000 per month to 5 of its doctors. • Monthly sales are £ 500,000. • £100,000 (£20,000 x 5) worth of monthly salaries should be matched with £500,000 of revenue generated. • Net profit for this month would be: 500,000 -100,000 ------------------- £400,000

The MatchingPrinciple • The objective is to match the income receivableand the expenditure payableto the appropriate accounting period.

TYPES of ADJUSTING ENTRIES

Type 1: Prepaid Expenses • Prepaid expenses are the type of expenses which are paid in cash and recorded as assets prior to being used. • Prepaid expenses are also known as deferred expenses

Adjusting Entries for “Prepaid Expenses” • Let`s say you prepaid £15,000 for your property insurance on 1st September of the current year. • Make the appropriate adjustment as of the end of the accounting period. (i.e. 31/12/2012)

AdjustingEntries for “Prepaid Expenses” Original Entry: OnSeptember 1 the following entry would be recorded when the insurance was prepaid: DR Dec. 31 Prepaid Insurance 15,000 Cash 15,000 CR Prepaid Insurance Cash Debit Credit Debit Credit 15,000 15,000 15,000

AdjustingEntries for “Prepaid Expenses” Prepaid Insurance is an asset account – it is an amount owned by the company that has economic value. We will recognise Prepaid Insurance under current assets.

Analyzing an Adjusting Entry: • Each month, a portion of the prepaid insurance expires. • At the end of the accounting period, the Prepaid Insurance and Insurance Expense accounts must be updated for the insurance that has expired (been used).

Analyzing an Adjusting Entry:(Example 1) • What accounts are involved? • When something is “used up” it indicates an expenseaccount. • In this case, we need to debitInsurance Expensefor the expired insurance. • Furthermore, the asset,Prepaid Insurance, has decreased so we will credit this asset.

Analyzing an Adjusting Entry: £15,000 for 12 months = £1,250/month Policy purchased on Sept 1. Months that have expired between purchase and fiscal year-end 4 months (Sept, Oct, Nov, Dec) Amount of adjustment =(£1,250/month X 4 months) £5,000 (£15,000/12 )

Let’s record the adjusting entry; DR Dec. 31 Insurance Expense £5,000 Prepaid Insurance £5,000 CR Prepaid Insurance Insurance Expense Debit Credit Debit Credit 5,000 15,000 5,000 £10,000 £5,000

The Concept of Depreciation (Example 2) Depreciation is the systematic allocation of the cost of a depreciable asset to expense. The asset’s usefulness is partially consumed during the period. Fixed Asset (debit) Depreciation Expense (debit) On date when initial payment is made . . . At end of period . . . Accumulated Depreciation (credit) Cash (credit)

Depreciation expense (per period) Cost of the asset Estimated useful life = $2,500 50 $50 = Depreciation Is Only an Estimate On May 2, 2011, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Using the straight-line method, calculate the monthly depreciation expense.

Contra-asset Depreciation Is Only an Estimate JJ’s Lawn Care Service would make the following adjusting entry.

$15,00060 months = $250 per month Depreciation Is Only an Estimate JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and make the journal entry.

Depreciation Is Only an Estimate Accumulated depreciation would appear on the balance sheet as follows: Cost - Accumulated Depreciation = Book Value

Adjusted Trial Balance All balances are taken from the ledger accounts on May 31 after preparing the two depreciation adjusting entries.

Type 2: Unearned Revenues • Unearned Revenues are payments for future services to be performed or goods to be delivered. • At the end of each accounting period, adjusting entries must be made to recognize the portion of unearnedrevenues that have been earned during the period.

Adjusting Entries for “UnearnedRevenues” • Suppose that you are the owner of an Insurance company and on November 30tha customer pays £1,800 for an insurance policy to protect her delivery vehicles for six months. • Make the appropriate adjustment as of the end of the accounting period. (i.e. 31/12/2012)

Adjusting Entries for “UnearnedRevenues” • Initially, the insurance company records this transaction by; • increasing an asset account (cash) with a debit • increasing a liability account (unearned revenue) with a credit.

Adjusting Entries for “UnearnedRevenues” Adjusting Entry: DR Nov. 30 Cash £1,800 Unearned Insurance CR £1,800 Cash Unearned Insurance Debit Credit Debit Credit 1,800 1,800 £1,800 £1,800

Adjusting Entries for “UnearnedRevenues” • After one month on 31 December 2012, the insurance company makes an adjusting entry; • To decrease (debit) unearned revenue • To increase (credit) revenue by an amount equal to one sixth of the initial payment.

Adjusting Entries for “UnearnedRevenues” (£1,800/ 6months)= 300per month Adjusting Entry: DR £300 Dec. 31 Unearned Insurance Vehicle Insurance Revenue £300 CR Unearned Insurance Vehicle Insurance Revenue Debit Credit Debit Credit 300 1,800 300 $300 $1,500

Adjusting Entries for “UnearnedRevenues” • If we do not include adjusting entries to show the earning of previously unearned revenues ; • We overstate total liabilities and understate total revenues and net income.

Type 3: Accrued Revenues • An asset class for goods or services that have been sold or completed but that have notyet been billed and/or paid for. • Accrued revenue is income that has been incurred but not received • Accrued revenue is also called accrued assets.

Adjusting Entries for “AccruedRevenues” • ABC Ltd. sold £1,000 of products to a customer who is not required to pay for 60 days. • The sale is recorded by ABC Ltd. on the income statement as revenue and on the balance sheet as a current asset • Even though no money will be received until later. (The sale process is occurred)

Adjustıng Entries for “accrued revenues” Initial Entry: DR Receivables (Current Asset) £1,000 Dec. 31 Revenue £ 1,000 CR Receivables Revenue Debit Credit Debit Credit 1,000 1,000 1,000

Adjusting Entries for “accrued revenues” • The concept of accrued revenue is needed in order to properly match revenues with expenses. • The absence of accrued revenue would tend to show excessively low initial revenue levels. Thus, low profits for a business

Adjusting Entries for “AccruedRevenues” For example; • Muffin Ltd. rented its office to Cookie Ltd. for £500 a month. • Muffin Ltd. has not received December rent of £500 from Cookie Ltd. • What figure of rent receivable should be shown as income for Muffin Ltd. for the year ended 31/12/2012

Adjusting Entries for “AccruedRevenues” Adjusting Entry: The adjusting entry at the end of December is to debit rent receivable and credit rental revenue by £500. DR Rent Receivable (Current Asset) £500 Dec. 31 Rental Revenue £500 CR Rent Receivable Rental Revenue Debit Credit Debit Credit 500 500 500

Adjusting Entries for “AccruedRevenues” • After one month, on January 2013 Muffin Ltd. received the rental income of £500 form Cookie Ltd. • What would be the double entry? • To increase (debit) as cash is received. • To decrease (credit) as rent is paid by Cookie Ltd.

Adjusting Entries for “AccruedRevenues” Adjusting Entry: The adjusting entry on January 2013 is to debit Cash / Bank and credit Receivable`s account for £500. DR Cash or Bank £500 Jan. 31 £500 CR Rent Receivable Rent Receivable Cash / Bank Debit Credit Debit Credit 500 500 500 - - 500

Type 4: Accrued Expenses • Accrued Expense is an expense incurred but notyetpaid. • A journal entry is created to record the expense, as well as an offsetting liability (which is usually classified as a current liability in the balance sheet). • The absence of a journal entry result in reported profits being too high in that period. (as expense will not be reported in the FS)

Adjusting Entries for “Accrued Expenses” Examples of expenses that are commonly accruedinclude: • Interest on loans, for which no lenderinvoice has yet been received • Goods received and consumed or sold, for which no supplier invoice has yet been received • Services received, for which no supplier invoice has yet been received • Wages incurred, for which payment to employees has not yet been made

Adjusting Entries for “Accrued Expenses” For example; • Green Ltd. enters into a rental agreement to use the trucks of Car & Cars Ltd. • The term states that Green Ltd. will pay monthly rentals of £2,000 at the end of each month. • The lease started on July 1st, 2012. On July 31, the rent for the month has not yet been paid and no record for rent expense was made.

Adjusting Entries for “Accrued Expenses” • What would be the necessary adjusting entry for rent expense? • In this case, Green Ltd. has already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded as an expense.

Adjusting Entries for “Accrued Expenses” Adjusting Entry: The adjusting entry at the end of July is to debit rent expense and credit rent payable for £2,000. DR Rent Expense £2,000 July. 31 £2,000 Rent Payable CR Rent Expense Rent Payable Debit Credit Debit Credit 2,000 2,000 2,000

The Accounting Cycle Accruals and Deferrals